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Renewed Focus on Digital Asset Risks by the Division of Examinations

VerifyInvestor.com

RENEWED FOCUS ON DIGITAL ASSET RISKS BY THE DIVISION OF EXAMINATIONS.png

The Division of Examinations (formerly the Office of Compliance Inspections and Examinations) has announced in a recent Security and Exchange Commission press release plans to continue their focus on the potential risks of digital assets. The SEC taking the digital asset category seriously lends legitimacy to that industry and hopeful is a prelude to a more robust digital asset industry in the United States. In the short term, however, the Division of Examinations intends this study to be used in regulation and transparency for companies and investors looking to use digital assets more in their investments and funds.

Investment Advisers

For Investment Adviser using digital assets or digital securities for private funds (such as Rule 506(c) funds, the Division of Examinations has determined several areas of focus to assess risk. Here is a basic breakdown of each area of focus:

  1. How digital assets are classified in terms of whether or not they can be considered securities.

  2. Due diligence on the digital assets themselves.

  3. Evaluating and reducing the risks associated with digital assets such as KYC/AML and security threats/breaches.

  4. Management of digital assets to investors such as distribution and potential conflicts of interest.

  5. Execution of advice for their investors.

Additionally, the Division of Examinations will be looking into Investment Advisdrs’ - portfolio management, books and records, custody, disclosures, pricing client portfolios, and registration issues.

Broker-Dealers

As the Division of Examinations has continued to observe the practices of Broker-Dealers, they have identified several areas of focus in regards to digital assets. Here is a summary of those areas:

  1. Safekeeping of funds and operations - in looking at the operations of broker-dealers, the Division will focus on how the safety of digital assets is handled in terms of the custody of the assets.

  2. Registration requirements - the broker-dealers will be examined for compliance with registration requirements especially with regard to any affiliated institutions or companies.

  3. Anti-Money Laundering - this is one of the Division’s largest focuses on broker-dealers as they have dropped the ball with their AML consistently. The Division needs to examine broker-dealers and ensure they comply with regular AML checks and utilize government institutions such as the Office of Foreign Assets Control.

  4. Offerings - broker-dealers should pay attention to underwriting and private placement requirements with regards to their digital assets. Depending on the offering type a broker-dealer may have extra compliance requirements such as verifying accredited investors for Rule 506(c) offerings.

  5. Disclosure of conflict of interests - since broker-dealers may be working in multiple capacities in multiple avenues an examination of potential conflicts of interests is especially important.

  6. Outside business activities - FINRA related activities of the staff of broker-dealers should be reviewed for compliance in terms of whether they are considered outside business dealings or should be under the supervision of the broker-dealer.

National Securities Exchanges and Transfer Agents

Although investment advisers and broker-dealers are the main focus of the Division of Examinations, they are also focusing on national securities exchanges and transfer agents. Since digital assets are so new an examination of platforms that facilitate the trading of ledger-based assets is needed. This is to determine whether those platforms should operate as an exchange or use some sort of exemption to exchange-based compliance. Furthermore, if a platform does meet the requirements of an exemption they may want to consider and review if the ATS or alternative trading systems are right for them.

For trading agents, the advent of digital ledger-based trading and digital assets has also caught the attention of the Division and they are reviewing how quickly and accurately trading agents are conducting their transactions in the digital asset space.

All of these actors in the digital trading of securities and assets industry need to look at their own practices and ensure they are meeting or will meet the SEC’s requirements. As this space is so new and the SEC has lagged behind companies and funds should be prepared for increasing review from the SEC and evolved to meet both industry and regulatory trends. Keep updated on this fascinating industry on the VerifyInvestor.com blog.

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